How does the Options market work and can you use a lifelike example of a put / call position which is relatable?
In: Economics
Lets say Bob buys apples, and Sam sells apples.
The current price of apples on the market is $1 per apples, but if there’s a drought, there will be fewer apples, thus maybe apples will be worth $2 per apple.
So Bob wants to buy apples in four months. He could either just wait to buy them at that time, but he doesn’t know when the price will be. Bob thinks the price will go up to $1.25 per apple and he knows he’ll need apples. He calls sam, and he says hey, I’d like an buy a Call which gives me an option to buy 100 apples at a price of $1.10 per apple in four months. I’ll give you $5 as a premium for this deal.
Sam thinks to himself that this is a good deal. If apples are worth more than $1.10, he’ll still make $1.10 per apple, but if apples are less than $1.10, he’ll make $5 from the premium, and he’ll just sell his apples at market price.
Bob and Sam both feel like winners. Sam has made guarenteed money, and Bob isn’t at a risk of losing a bunch if he needs to buy apples when they’re more expensive.
Now we have Ted, who is an apple trader. Ted thinks that apples are going to go up to $1.25 per apple from their current $1 price. He makes the same deal with Sam, but Ted actually doesn’t care about owning apples. He spends $5 and now has a right to buy 100 apples at $1.10 per apple. Ted wants the price of apples to go up so he can use this call option to buy $100 apples for $110 , but immediately sell them for $125. He’ll make a $10 profit after his $5 premium. If he was really lucky, and apples were worth $2 per apple, he would make $85 from his $5 premium.
Now if you want to understand the options market, replace apples with stocks. Options allow you to set a future price you have the right to buy a security for at that price. It’s good for the seller because they reduce risk and gain a premium. Its good for the buyer because they reduce risk but lose a premium. It’s good for a trader because they can make large amounts of money with a smaller gamble. In the end, everyone has a reason to get involved, just not everyone wins.
Puts are a little harder to understand. They’re a bet that the price of the commodity or security will go down.
You can see Options as a “price guarantee” for something you want to buy / sell in the future, but you want to agree on the price in advance.
**Put Option Example**: You are an American company and get a contract from an EU company. You’ll get the payment of one million EUR for your work in one year. Today, 1 EUR is roughly 1.10 USD, but you don’t know what the exchange rate will be in a year.
If you want to “insure” that exchange rate, i.e. make sure you really get 1.1 million USD in a year, you can buy a put option on the EUR/USD exchange rate. A put option on EUR/USD with a strike of 1.10, expiring in one year and a total contract of 1 million EUR will guarantee that you at least get the 1.1 million USD in one year. This put option gives you the right, but not the duty, to sell 1 million EUR and receive 1.1 million USD in return. If the exchange rate were to rise, then you just let the option expire (i.e. you don’t exercise your right), and do the exchange at the current rate.
**Call Option Example**: For this job above, you’ll need a part from a Canadian company which costs 100k Canadian Dollars (CAD). Today, that’s 75k USD. You’ll need that part in 6 month, which is also when you’ll pay the Canadian company. Again, if you don’t want to gamble with the exchange rate, you’ll get a call option on the USD/CAD at strike 1.33 (current rate), expiry in 6 months, total contract of 100k CAD. The Call Option gives you the right, but not the duty, to buy 100k CAD for 75k USD in 6 months.
TL;DR : For you, as a retail investor, they work like going to Vegas and hitting the roulette table. For an investment bank they’re like going to Vegas and playing blackjack while counting cards.
Longer version: Basically a Call is putting a deposit to buy 100 shares a a certain price at a certain date. Called the strike price. If the strike is somewhat more than the current value chances are the amount you’ll have to put down as a deposit will be small, as people think it’s unlikely the stick will reach that value. This allows for potentially large gains. Say a stock is $100/share, and you buy a Call contract for the option to buy 100 shares at $110 in one month. That won’t cost much – chances of a stock shooting up10% in that timeframe is low. For math we’ll assume the Call is $1/share. You’re lucky! The stock goes to $120!!! This means you can buy them for $110 and turn around and sell them for $120. Or you can just sell the Call for $1000. In other words your Call is now worth $10/share. You just made $9 per share, or $900 profit off a $100 bet. Congrats.
OTOH if the stock ends the month at anything less than $100 your Call is literally worthless and you lose your wager.
You can also sell Calls. In this case you oblige yourself to sell shares at a set price. IOW you’re the House collecting wagers. In the scenario above you collect the $100 wager an of the stock goes up to $120 you have to cough up $1000. As a retail investor you’re normally only allowed to do this if you own the stocks you’re selling calls for, as the potential losses are huge.
Puts are the mirror of Calls. Instead of buying the right to buy at a certain price you buy the right to force sell at a certain price – you make money on this if the stocks go down in value so you can sell them for more than they’re worth.
In any of these cases – the “person” at the other end of the wager from you is most likely an enormous investment bank making their bets backed by entire buildings full of math and economics PHDs, each with years of investment experience and supported by enormously powerful custom built computer systems running code written by some of the best software engineers on earth that updates their valuations in nanoseconds based on developing news.
Examples. I’m going to use baseball cards.
My friend has a card that’s worth $100 today. It’s pretty rare but you can buy them on ebay for $100. Now this player, I think he sucks and that his card is WAY over valued. I think that this card will fall to $50 within the next year.
So my friend and I cut a deal. He will lend me his card, and I will give him back a card in 12 months time. Same player, same card condition. It won’t be his literal card, but he does not care as long as it’s the same player in the same condition. In exchange for borrowing his card, he charges me $5 for the year.
So I borrow my friends card, and sell it on Ebay for $100. I wait 1 year and it turns out I was right! I buy a card, same player and quality, for $50 and return it to my friend on time.
So I’ve made a profit of $45 ($50 profit less the $5 rental).
That’s a “put” option. The key concept is that one stock in a company is exactly equal to any other stock in that company. So I can borrow a stock, sell it, then purchase it at a later time and return it to the lender. The lender does not care if they get returned a stock that is not the literal stock that was borrowed as long as it’s the same class and the same company, stocks are interchangeable that way.
Therefore a put option is a bet on a stock (or baseball card) value going down over time. A bad thing to consider is that losses are basically unlimited. If I’m wrong and the stock price goes up and not down, I’m still obliged to purchase the stock and return it to the lender. Since the stock price “could” go up infinity, my potential for loss is also infinite.
A call option is basically the exact opposite. Rather than a contract to borrow a stock and return it at a later time, it’s a contract to purchase a stock at a later time.
Back to the baseball cards. My friend has a card that he thinks will keep a constant price or even fall a little but he does not want to sell it right now (for whatever reason). I think the price will go up, and I really want to buy it.
Currently the card is worth $100. So we write a contract. I have the option (but not the oblation) to buy the card in 1 year’s time for $100, and in exchange for this I’ll also give him $5 today.
If the card’s market price goes down, I lose my $5 but don’t have to buy my friends card, I can go buy some other card. If the market price goes up to $150, I can force my friend to sell me the card for $100. So (accounting for the $5 fee) I have now made a profit of $45!
Now these options don’t have to be at the current market price. Often these kinds of options are used as a form of employee compensation. Lets say I work for a large company and their stock price is currently $100 per share.
I’m working on a big project that will make the company a lot of money. If I’m not successful it will not make a lot of money. I want more money to keep doing this work for this company, but my company does not want to take the risk if I’m not successful. So we agree on stock options.
In addition to my salary, I get the option to buy stock at a later date. So in 1 year’s time I have the ability to purchase stock at today’s price ($100). If my project is a big success, surly the stock value will go up over that year. If my project fails, the stock price will not change. I receive 1,000 of these options.
2 scenarios:
First, one year later and my project is a smashing success. Stock price is up to $150. I take my 1,000 options and use the choice to buy stock for $100 each. I spend $100,000 to use all 1,000 options at $100 per option. I immediately own 1,000 shares of company stock. Stock that is currently worth $150,000. Effectivly my company has paid me a $50,000 bonus.
Second scenario. My project is a flop. Stock price stays at $100. I don’t do anything with my stock options and they expire. I don’t get a bonus and am sad.
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